What is a Defined Benefit Plan? - Definition & Examples

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Let's take a look at how a defined benefit plan works and what sort of payment plans are available to employees as an alternative or supplementary benefit in retirement.

Defined Benefit Plan

Tony's going through the onboarding and orientation for his new job and noticed that as a retirement benefit the company offers a defined benefit plan in addition to a 401(k). He's never heard of this kind of retirement program before, and wants to learn more about it. Let's listen in as the human resources manager explains to Tony what is unique about this retirement program and how it works.

Definition

In a defined benefit plan monetary benefits are paid to a retired employee based on a formula that is already established and known well in advance of retirement. Typically the formula includes factors such as years of service, age, and the employee's salary. Unlike a regular pension fund where the money paid out in retirement varies based on the company's investment returns, a defined benefit plan offers a guaranteed amount based on the formula. A defined benefit plan can be offered as an extra retirement savings plan in addition to offerings such as a 401(k) or as the only retirement benefit option.

Here's how it works. The company contributes money into an investment account. Occasionally the company requires or permits employees to make regular contributions into the fund as well. The pool of money is then invested in securities such as mutual funds and bonds. These kinds of investments provide predictable and stable returns to fund retiree payments without the volatility of high risk single stocks or the low returns of a simple savings account. Payments to the retirees come out of this account as described in the plan. However, if the investment account doesn't make enough money on the investment returns, known as a shortfall, the company will have to make up the difference in the amount owed to retirees by tapping into the company's other financial resources.

Tony finds out that his decision for when to finally retire can make a big difference in his benefits. Working an extra year can increase the amount, not only because of the additional credit for years of service but also because he will likely have a higher final salary.

Examples of Payment Plans

Defined benefit plans can pay out benefits in a number of ways that can be optimal for different individual financial situations. At Tony's company, the employee receives $100 a month for each year of service with the company once they have reached age 60. If he works for 30 years, he will receive $3,000 each month when he retires. The company might also offer an alternative plan where the employee receives a larger single lump sum.

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